The LBO bubble has burst, and in its place has arisen a vastly scaled down and more conservative market for private equity investments. Andy Thomson reports on the lack of liquidity, fears over the economy and where new opportunities lie.

Here we are in the post-credit crunch era – a bleak one for those leveraged financiers who enjoyed roaring times until the summer of 2007. But while the large buyouts they gorged on have disappeared from the menu and the party hats have been packed away, no-one can accuse these key actors of having lost their sense of humour – even if it is of the gallows variety. There's a joke doing the rounds about a leveraged finance professional who asks his superiors what his career alternatives are in these straitened times. The answer: “Dubai, Mumbai, Shanghai or goodbye”.

In the developed markets of the West, as opposed to the still relatively vibrant markets of the East, the resolution to the current dearth of large deals is, in many cases, to wave goodbye. Witness developments in the European leveraged finance division at Citi, for example, where a team of 27 was recently reduced to 14 – seven made redundant and the other seven reassigned to different roles within the bank.

Anecdotal reports suggest Citi will be far from alone in trimming back resource dedicated to a revenue generator that simply isn't capable of generating much revenue at the

current time. A recent survey by data provider Dealogic showed global investment banking fees generated by buyout firms were down 77 percent to $1.16 billion (€734 million) in the first quarter of 2008 compared with the equivalent three months last year. Over the same period, the volume of deals slumped by 65 percent and the value from $180 billion to $63 billion.

There are many reasons lying behind these sobering figures. One of the foremost is the decimation of an institutional investor base which had long played a significant role in buyout syndications in the US and which also became a huge driver of the LBO boom in Europe over the last few years.

“It's very difficult to secure a meaningful amount of bank finance,” says William Allen, a managing director and joint head of European debt advisory services at investment bank Houlihan Lokey. “During the boom, underwriters were relying on institutional investors such as CDOs and hedge funds accounting for 60-70 percent of the liquidity in the primary market and 80 percent in the secondary market. That liquidity went overnight.”

Therefore, Allen continues, “the banks are not underwriting because they see too much syndication risk. It's a bank-only market supported by a handful of mezzanine funds. The exit of so much market liquidity has put a major cap on underwritings.”

According to Richard Ginsburg, a banking and finance partner at law firm Weil Gotshal in London, concerns also extend to the financial condition of certain banks. “Historically, decisions have been based on who is the sponsor, what's the asset like, the sector it operates in etc. But now, another question to ask is ‘who are the banks in the syndicate and will they still be interested in funding the deal at closing?’ Nobody underwriting a deal over recent years has had to worry about the health of most banks. But that is a question being asked at all levels today.”

And it's not just new deals being hampered by the liquidity drought. When UK gaming group Gala Coral recently announced a £125 million equity injection by its private equity backers Permira, Candover and Cinven, it was suggested in some quarters that the deal was somehow illustrative of troubles ahead for private equity portfolio companies. In fact, the well-documented strife at Gala Coral has had much to do with factors peculiar to its sector – notably, the UK's smoking ban.

The real significance of the deal may lie instead in what it says about the lack of re-financing options available today. “Different strategies and sectors will be affected in different ways, you can't make a link and assume that what happens with one business will occur elsewhere. But where problems arise, equity injections into businesses by their private equity owners will be more common,” says Allen.

He adds that when markets were more liquid firms could refinance deals into a lower cash-cost structure and get rid of amortising term debt or put in a PIK element. Those days are gone and the balance of power is with the banks. “They won't give waivers on the debt without getting something in return – a re-pricing, a fee for consent, or an equity injection.”

While the “balance of power” may have shifted to the banks now, during the LBO heyday the ball was firmly in the sponsors' court. In the US, covenant-lite deals were commonplace for some time before they arrived in Europe. But although Europe only saw a relatively small number of pure cov-lite deals, there was nonetheless a notable shift towards greater covenant headroom. “Frequently, you can go 30 percent below the business plan on deals structured 18 months to two years before the credit crunch and you won't breach your covenants. By the time you trigger a covenant breach, probably all the equity value has gone anyway,” says one banking source.

What this means is that, rather than having to negotiate with the banks as soon as problems with portfolio companies arise, control over their destiny rests with sponsors for a longer period. Thomas Drewry, founder and managing partner at London-based executive search firm Veni Group, says it is notable that private equity firms “have turned their focus on hiring senior operating partners and restructuring experts. Above all, you must keep your existing portfolio performing.”

The importance of this – and the scale of the challenge – is emphasised by Paolo Mazzini, a senior director in European leveraged finance at ratings agency Fitch Ratings, who says: “The type of weak credits that were able to raise capital during the good times are the ones most exposed to liquidity issues in the coming economic slowdown. Some companies that were acquired in 2006 and 2007 are highly leveraged with only a thin equity cushion. As market conditions deteriorate, sponsors will be forced to delever their portfolio credits and hold them for longer to gain back the equity cushion.”

But while the credit crunch may be giving private equity firms reasons to be concerned, they should never be accused of lacking an eye for the main chance. Hence, they have been seen occasionally buying up cheap debt from syndicate members in their own deals. In March Danish telecom TDC, owned by Apax Partners and Kohlberg Kravis Roberts, repurchased €200 million of its senior debt, while French buyout firm PAI Partners recently bought back second lien debt associated with its €2.4 billion acquisition of Lafarge Roofing in April 2007.

Loan buy-backs are not without controversy, however. Some lawyers have argued that they are contrary to terms of the Loan Market Association standard loan form, even as others have proclaimed their perfect legitimacy. “There is a lot of interest from sponsors in doing this,” says Ginsburg. “But there are also issues beyond just whether the loan documents restrict a debt purchase. While some say there are restrictions in the documents, others say the restrictions fell out of the documents some time ago.”

Arguably of more import, Ginsburg continues, are the potential accounting issues that stem from a borrower buying its own debt: “If one lender in the banking group is repaid and the others aren't, there is a question as to whether that lender is obliged to share the surplus cash with the other lenders in the group. The theoretical question is: If you buy the debt back, have you just repaid a particular lender or have you bought the debt obligation? The way debt buybacks are structured is very important.”

In the mid-market, where the impact of the credit crunch may have been more muted than at the larger end but still has the capacity to handicap deals, innovation is also the order of the day. Observers here note, for example, the willingness of vendors to provide some of the finance for deals rather than accept a knockdown price. The private equity backer then pays off the debt out of the company's cash flow. “There's a lot more vendor financing, we've seen it twice in the last couple of months,” says John Wolfgang, chairman of global accounting and consulting firm UHY International. “Valuations are fairly high right now. Investors are looking at the values – and their ability to bankroll deals – a little sceptically.”

Meanwhile, Jonathan Trower, a managing director at Close Brothers, offers the opinion that the market has returned to the ‘norm’ of a few years ago – before, it might be argued, irrational exuberance got a grip. He says: “Terms and conditions have tightened with respect to covenant packages and the core structures of deals have changed. There is always an amortising tranche now in cash flow deals. In 2007 lots of deals were done with only non-amortising institutional tranches. The banks say they won't do that now. It's much more difficult to get deals done but those that do get done essentially have the same characteristics as a few years ago.” Adds Richard Howell, co-head of leverage finance at Lehman Brothers in London: “For the majority of banks, the notion of “open for business” or “closed for business” doesn't really exist, it's more about what terms are appropriate. Our perspective is that deals can get done as long as there is the right visibility around investor appetite, with an acceptable level of flexibility in the terms to take account of ongoing market volatility during the underwriting period.”

For some organisations, current conditions present an opportunity for a land-grab. Drewry points out: “Now is an opportune time to get into the leveraged finance business because banks which are still open for business are more likely to be granted quality airtime with the sponsors and are able to negotiate. This time last year, hardly any negotiation was possible.”

GE's European commercial finance division, for one, claims to have enjoyed a fruitful time lending to private equity deals lately, a claim not only backed up by several rivals but also by an impressive and growing roster of deal involvement (joint mandated lead arranger and bookrunner for £845 million of senior and mezzanine facilities supporting the PTP of Emap by Apax Partners and Guardian Media Group being one example).

Maurice Benisty, managing director for financial sponsors at GE Commercial Finance Europe, says GE's lead arrange activity was only launched in 2005 with the idea of building an industry focussed team arranging mid-market transactions for Europe's leading financial sponsors. He notes: “We secured six mandates in 2006, which increased to 10 in 2007, most of which were secured in the second half of the year. 2008 has been a significant improvement in our deal pipeline as sponsors recognise the value of our strong credit culture and continued appetite to lend in a tough market. We're now operating across the entire market, because there is no large end and expect to emerge as a leading arranger of European leveraged loans.”

But while GE's leveraged finance operation may have more reason to feel bullish than most (in spite of parent company GE's disappointing recent results announcement), Benisty volunteers the same anxietytinged question that has been aired time and again these last few months – and probably as frequently by barflies and dinner party guests as by media pundits. Namely: “What will happen to the economy as a result of the credit crunch?” While, nearly a year on since the birth of the crisis, a definitive answer remains elusive, some worrying signs are emerging.

Adam Hewson, GE's head of European capital markets, says: “Defaults are increasing in the US and there are general consumer worries in the US and Europe together with specific concerns about the housing market. These kinds of things will hit deals.” Hewson also suggests that while issues specifically affecting the leveraged finance market could be resolved by the third or fourth quarter of this year, “more issues with banking liquidity will feed into the real economy” and make the likelihood of any return to buoyant times a more distant prospect.

However, either those canvassed by PEI for this feature are not scared by such forecasts or at least are doing a good job of hiding their trepidation. UHY's Wolfgang, for example, says that some of his firm's clients have experienced strife, including one supplying products to the house-building sector: “The difficulties started two years ago, got worse in 07 and worse still in 08 – they're probably looking at another six months to a year before things get better.” On the other hand, though, a client making products used in solar panels “has grown fivefold in the last two years with no sign of slowing. Two years ago it opened a production plant in Spain and is doubling the capacity of that plant.”

Weil Gotshal's Ginsburg adds: “A lot of the gloom about the economy is based on anecdotes and a slight deterioration in EBITDA. In most of the deals that were closed in the past four years there have not been the covenant breaches that you might have expected in an environment where business is soft because interest rates (although not margins) are for the most part holding steady. We generally are not seeing financial covenants being missed, although certainly the coming months could be different.”

One thing's for sure: market observers are keeping an eagle eye on developments at the trophy assets private equity has acquired recently for signs of success or failure. One European banking source says: “If Boots is a homerun and EMI and AA do well, they could act as a trigger for an LBO revival.” By the same token, the source continues: “RJR Nabisco was the biggest deal for 20 years and had very average returns. If the clutch of LBOs that people hope do well end up doing badly, it could be another 20 years before the record deal size is broken again.”

But if that's a sobering thought, it should be borne in mind that leveraged finance professionals are likely not looking too far ahead in any case. Some are busy planning alternative careers. Others are checking flight times to the emerging market capital city of their choice.